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"As the Danish philosopher Soren Kierkegaard noted, life can only be understood backwards-but it must be lived forwards." ? Benjamin Graham. This quotation of Benjamin Graham, applies particularly to his own life. His difficult childhood and the challenges he faced as a young adult taught him many lessons. Lessons from which, he imbibed the principles of caution, careful analysis, and calm action, even in the face of adversity.
Benjamin Graham, the doyen of value investors was born in London in 1894. Not much later his family immigrated to the US where his father ran an unsuccessful import business. A few years hence his father died and whatever savings the family had, was lost in the recession of 1907. However, Benjamin proved to be good student and he won his way to a degree from Columbia University. He then took a job as a 'chalker' with the Wall Street firm of Newburger, Henderson and Loeb, to gain practical experience in finance. Soon he was employed on financial research for the firm, earning astronomical amounts and finally becoming a partner.
Setbacks, introspection and analysis
Graham was badly hurt by the Crash of 1929, but he managed to keep afloat with financial help from friends and by selling most of his personal assets. The crisis made Graham introspect deeply. He pondered on the sudden turn of events and tried to analyse the situation from the point of view of the investor. He thought about how to make investing a relatively logical business. The deep contemplation and the findings it engendered grew into the classic book on investing, 'Security Analysis', which he co-authored with Davis Dodd, another Columbia professor. First published in 1934, the book became very popular and is still in print! The basic premise of the book was that that it was possible to make sensible stock investments based on the 'intrinsic value' of a stock. Graham's recommendation was that stocks should be bought at a discount from this value. This strategy would protect investors from the vicissitudes of the market even in troubled economic times like the Great Depression.
"You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock; you must deliberately protect yourself against serious losses; you must aspire to "adequate," not extraordinary, performance." ? Benjamin Graham, The Intelligent Investor
Many present day big names in investment like Warren Buffet studied under Graham and sought jobs in his firm to have practical exposure to his investment style and strategy. Putting his years of research and day to day experience to good use, Graham published another gem of a book in 1949, the 'The Intelligent Investor: The Definitive Book on Value Investing: A Book of Practical Counsel'.
Investment Philosophy
"An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative."
? Benjamin Graham, The Intelligent Investor
If there is one word to describe Graham's investment philosophy, it would be prudence. Generally it is very difficult if not impossible to pinpoint the true value of any stock. So Graham devised a system for arriving at what he called the 'intrinsic value' and worked out a price below that at which it would be safe to buy that stock. There could be upturns and downturns in the market, while companies' performance might deteriorate over the years. Yet, the margin of safety would provide a cushion for investors.
"The true investor scarcely ever is forced to sell his shares, and at all other times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgment." ? Benjamin Graham, The Intelligent Investor.
Investment Strategy
"The intelligent investor is a realist who sells to optimists and buys from pessimists." ? Benjamin Graham, The Intelligent Investor.
The typical Graham strategy is to buy what is called a 'net net' stock. According to Graham this is a company that is worth 'more dead than alive'. This point is reached when the share price of the company is equal to or less than the total of cash and current assets the company possesses. Thus, if the company closed shop, the investor would receive more money than if he/she sold at the current stock price. Graham usually would purchase stocks at about two thirds of the net-net value. When you accumulate a range of such stocks you will far outperform the indexes. Such stocks were common during the Great Depression but are less common today. Hence this method is no longer favoured by investors.
The Defensive investor vs. The Enterprising investor
Graham's investment strategy was built around the kind of investor making the investments. Based on their objectives, Graham divided investors into 'defensive investors' and 'enterprising investors'. His books focussed on the defensive investor thus revealing his preferences. He defined a defensive investor as one who while aspiring for a good rate of return, nevertheless believed in keeping the capital intact. On the other hand, the enterprising investor would be a risk taker, even in cases where research data did not warrant optimism.
"The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator's primary interest lies in anticipating and profiting from market fluctuations. The investor's primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.? Benjamin Graham, The Intelligent Investor.
An important point to note is the enterprising investor would be unlikely to follow the rules for a defensive investor as enunciated by Graham. Such an investor would not think twice about investing in companies which have large debts, which have not paid dividends and which have lower capitalizations. They would even go for distressed stocks, spin offs and arbitrage situations.
Investment criteria for the Defensive Investor
For defensive investors, Graham proposed the following strategy. His normal distribution of investible funds was 50/50 between bonds and stocks. Yet when market conditions warranted, he proposed 75/25 and 25/75 ratios to take the best advantage of under and overvalued markets. Usually he advocated keeping from 10 to 30 stocks.
The following are the criteria as defined by Benjamin Graham:
Do not invest in a financial company. Choose a non technology company. Ensure that the company has a certain sales volume that will help the company prosper as the top line goes up. Choose companies that pay out dividends A current ratio of over 2, except for telecom companies and utilities. These companies can have a lower current ratio as they regularly finance themselves through sales of bonds and shares. The long term debt should be less than net current assets. The company should have seen 30% EPS growth in the past ten years There should have been no negative EPS in the past five years P/E lower than 15 P/E times P/B less than 2.2 Total Debt- Equity ratio should be less than 100% for industrial companies. It should be less than 230% for railroads, utilities and phone companies. (Valuewalk)
The Graham Newman partnership
In 1926, Benjamin Graham, while still taking classes at Columbia University, formed a partnership with a stock broker, Jerome Newman. The Graham -Newman partnership was a great success. The partnership continued till Graham's retirement in 1956.
Except for 1929 the firm never lost money in any year. In fact the firm posted robust earnings of 20% annually, beating the S&P 500's average of 12.2%. For ten years from 1936, earnings before management compensation amounted to $245 per share. This contrasts with the $99 price of the initial issue. Of the total earnings, $204 was paid out to investors, $161 in cash and dividends. The annual return amounted to 17.6%, while Standard Statistics Poor's Index of 90 stocks showed a return of 10.1%, and the Dow Jones recorded a 10% annual return.
By the time the firm closed business in 1958, $840.62 had been distributed to shareholders. This represents a whopping 750% return over thirty years. Taking distributions into account, the firm managed 17% average annual returns. The Dow Jones return in the same period was 4.7%. While assessing these sensational figures one must keep in view that these years covered the Crash of 1929 and the Great Depression.
The firm's success was related to its performance linked compensation structure. Each director received a base salary of $15,000, just under $200,000 today, based on CPI figures. In addition to this base salary, the directors were entitled to a) 12.5% to each, of the excess of the dividends paid during the year over an amount equal to $0.018 per share per day, or b) 10% to each of the excess of the overall net profit, adjusted to reflect unrealized appreciation or depreciation in the market value of the securities. (Valuewalk)
Having left an indelible mark on the investing world, Graham passed away in 1976 at the ripe old age of 82.
Words of Wisdom
"The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right."
"But investing isn't about beating others at their game. It's about controlling yourself at your own game."
"Outright speculation is neither illegal, immoral, nor (for most people) fattening to the pocketbook. More than that, some speculation is necessary and unavoidable, for in many common-stock situations there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone. There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose." ? Benjamin Graham, The Intelligent Investor
"With every new wave of optimism or pessimism, we are ready to abandon history and time-tested principles, but we cling tenaciously and unquestioningly to our prejudices.
"In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion." ? Benjamin Graham, Security Analysis.
Content is prepared by Wealth Forum and should not be construed as an opinion of HDFC Mutual Fund.
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Wise Advice: Learn
Fund managers around the world - from Warren Buffet downwards, have learnt the art and science of value investing from Benjamin Graham and his seminal books on the subject of value investing. But, there's more to Graham than security analysis and understanding and valuing stocks. His understanding of the minds of investors and the business of investing is perhaps as prescient as his understanding of stocks. Here are a few of his memorable observations: